Indian bank stress tests expected to provide only superficial reassurance

It seems that bank stress tests are catching on. In the wake of the US tests, whose results were published in May 2009, and the less exacting European ones, whose results came out on July 23, India is poised to embark on stress tests too.

However the Indian bank tests are likely to be more opaque than the recent European ones – and their results will have to be taken with a bigger pinch of salt, according to a recent guest blog post in FT beyondbrics, the FT's emerging markets hub.

On July 27 the Indian Reserve Bank confirmed its intention to carry out stress tests on Indian state-owned and privately-owned banks in the hope of providing reassurance about the resilience of the country's banking system. On the same day the IRB raised interest rates more sharply than expected – to 4.5%-5.75% - for the fourth time in a year, largely in response to higher inflation and a potentially overheating economy (GDP growth is expected to be 8.5%-8.6% this year and next).

Incidentally, as Stephanie Flanders pointed out in a recent BBC blog post, Indians no longer see their nation's closed financial system as a source of weakness. It is increasingly preferring to cut itself off from internatonal markets.

RBI governor Duvvuri Subbarao admitted that India would be “learning on the job” as it seeks to review of capital, liquidity and leverage standards of the nation’s banks, the majority of which remain state-owned.

India’s banks emerged remarkably unscathed from the global financial crisis of 2008-09 despite suffering a liquidity squeeze. Only ICICI, India’s largest privately-owned bank, needed explicit liquidity support during the mother of all crises.

However, in a that FT beyondbrics post mentioned above, Hemindra Hazari, head of research at Hyderabad-headquartered Karvy Stock Broking warned that the government’s proposed tests may end up being more spin than substance.

He painted a disturbing picture of the state of Indian banking, adding that New Delhi has good reason to keep both the results and the methodology of the tests under wraps.

According to Hazari, India's banks have widely used accounting jiggery-pokery to disguise their true bad debt position and suggestedthat they are in a far worse state than they are likely to let on to the stress testers.

Hazari said that while India’s banks may have the trappings of strength - having avoided the “cancers of subprime lending and investments in dodgy sovereign paper” - hidden dangers lurk beneath the surface.

In particular, he noted that the quality of their asset bases is “extremely mixed” and that their non-performing assets surged by 23% in the fiscal year 2009 and by 28% in the subsequent year.

Hazari does not regard non-performing assets as a reliable gauge of asset quality. This is because from 2009-10, the RBI allowed Indian banks “to classify dubious assets as restructured standard loans which are not classified as non-performing assets and which require minimal additional provisioning.”

Hazari added:

It is this nebulous category of assets, which bankers insist are of sound quality but are having “temporary” cashflow problems that have suddenly surfaced and rest innocuously in the notes to accounts on bank balance sheets.

Hazari said the banks’ restructured asset portfolios dwarf the quantum of their reported NPAs. In a sample of 28 banks, the broker's research indicated that restructured standard loans grew more than fourfold in 2009-10 and 1.6 times in 2009-2010. Together with net non-performing assets, Hazari said they constitute 4.6% of net loans and an alarming 47.5% of equity in 2009-2010. The picture is even worse in the government-owned sector where net impaired assets constitute 61% of equity.

The ratio is higher in government banks since they lend more heavily to SMEs and farmers and as a result of the government’s failure to regularly recapitalize the state-owned sector.

In conclusion, Hazari wrote that the:

tumour is still malignant but as the banks continue to report higher profits, the alarm bells remain silent. Bank performance rests on the tripod of solvency, profitability and liquidity. In the case of the Indian government banks, solvency is questionable, profitability is lower than reported, but liquidity is robust.

He believes the Indian government urgently needs to recapitalize state-owned lenders but warned that, owing to fiscal constraints, this is unlikely to happen overnight.

Another potentially disturbing sign is that Indian private banks are currently offering among the best rates to UK-based savers. Bank of Borodo is offering a market leading rate of 4.9% for a fixed-rate savings bond.

Historically this has been a sign of overseas banks desperate to secure new deposits to correct a loan-to-deposit ratios that is tilting to the left back home. Remember IceSave, the UK online bank owned by Iceland's Landsbanki in 2006-07?

Even so, Moody's is convinced that India has a highly supportive framework forits banks. In a recent note the ratings agency said the government "is currently recapitalizing a number of public-sector banks."